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BULLS & BEARS: SEC task force looks into soft-dollar arrangements

June 6, 2005

Conflicts of interest in the securities business have probably existed ever since the first stocks were traded in 1792 under the buttonwood tree at the tip of Manhattan.

With the formation of the Securities and Exchange Commission in 1934, regulators attempted to mitigate conflicts via securities laws and full disclosure requirements. An issue that is receiving attention these days from the SEC, one investors are probably not aware of, are the "soft-dollar" arrangements prevalent in the industry.

In May 1975, when the SEC abolished fixed commission rates, Congress created a safe harbor to protect investment advisers from claims they had breached their fiduciary duty if their clients paid higher commission rates in exchange for research. Thus the "soft dollar" industry was born and, as they say, give them an inch and they'll take a mile.

In a typical soft-dollar arrangement, mutual funds and money management firms receive rebates on commissions from the brokerage firms that execute their stock transactions. The rebates come back as cash credits and the firms use them to pay for "research services."

What is noteworthy is that these commissions are paid by the clients of these firms and are generally higher than the fund or adviser could have negotiated if it were not using commissions for services.

At some mutual funds and advisory firms, what constitutes research services has been stretched to include other operating expenses of these firms. In a 1998 SEC study, the regulator concluded that while most products and services obtained by advisers fall within the definition of research, about 33 percent of soft-dollar credits are now used to pay for office rent and computer/software equipment. In some instances, soft dollars were used to pay salaries, marketing expenses, cellular phone expenses, hotel and rental car costs.

Recently, the SEC has formed the Soft Dollar Task Force that is now considering a better definition of "research services" and improved disclosure by firms that have soft-dollar arrangements.

It is difficult to imagine why anyone would willingly pay inflated commissions for Wall Street research. Its "value" to investors was exposed during the market bubble. In addition, if a mutual fund or advisory firm feels a need to obtain research from independent third-party sources, it should be paid out of the management fees they charge their clients.

Last, the use of soft dollars to pay for routine business expenses such as computer equipment and other office expenses should be abolished. Those expenses should be paid out of the firm's revenue and should not be carried on the backs of the firms' clients in the form of higher commissions.

Furthermore, the use of soft dollars has a perverse effect. A firm that trades securities more actively, and hence costs its clients more in commissions, receives more benefits in the form of soft-dollar rebates. This is the last thing that should be encouraged, as hyperactive trading is the scourge of long-term investment performance. The frictional costs of commissions only serve to decrease clients' investment returns.

For investors, a wise course of action is to dig deeper into the fund prospectus or advisory agreement to determine how much money they are paying to fund any soft-dollar arrangements.



Ken Skarbeck is managing partner of Indianapolisbased Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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